What Are They?

Municipal bonds, known as "muni bonds", are bonds issued by a state, city, or local government. Interest payments on municipal bonds are generally exempt from Federal taxes. If purchased by a resident of the state that issued the bond, the interest payments may be exempt from Federal and state tax, and if bought by residents of the locality that issued the bond, the interest payments may be exempt from Federal, state and local taxes. For that reason, municipal bond managers offer state-specific bond funds.

ETFs are typically index funds which trade close to or at their underlying asset value. In contrast, closed-end funds tend to be actively managed, and due to their structure can trade at significant premia or discounts to their net asset values.

Closed-end municipal bond funds often use leverage: the fund borrows money at what low short-term interest rates to purchase longer term bonds that pay higher rates. While leverage increases a fund's yeild and dividend ratio, it also raises risk because a rise in short term rates and decline in long term rates can reduce the fund's net interest income and payout.

Some of the CEFs listed here offer insured muni bonds. The insurance guarantees the payment of principal and interest on a bond issue if the issuer defaults, but the value of the insurance is dependent on the financial strength of the insurance companies. The insurers include: AMBAC Assurance Corporation, CIFG Assurance North America, Inc., Financial Guaranty Insurance Company, Financial Security Assurance Inc., MBIA Insurance Corporation, XL Capital Insurance, Assured Guaranty Corp., MGIC Radian Financial Group and American Capital Access.

Why & How To Use Them

Bonds are a core component of diversified portfolios, as they behave differently to stocks and therefore dampen volatility. Bonds are also safer (ie. less volatile) than stocks and generate interest income, making them particularly suitable for people in and nearing retirement. However, bonds tend to produce lower long-term returns than stocks, so younger investors who can tolerate more short-run volatility often opt for a low or zero allocation to bonds.

US municipal bonds are safer than corporate bonds but less safe than US Treasury bonds. So they tend to offer higher returns than Treasuries but lower returns than corporate bonds.

Municipal bonds are relatively illiquid -- they don't trade in large volumes, and buy-sell spreads may be wide. That makes them well suited to closed-end funds and ETFs, because fund managers can better manage the trading costs and spreads compared to individuals, and the ETF or closed-end fund structure reduces portfolio turnover compared to the traditional mutual fund structure.

The strongest reason to own muni funds: tax. Interest from US municipal bonds is usually exempt from federal, state and local taxes if the bonds are issued in the investor's state (check with your accountant). But some muni bonds are taxable, so you have to check the funds carefully.

Closed-end funds may be attractive when they trade at discounts to net asset value, despite their higher expense ratios and more limited holdings. For more on this important issue, see Further Reading below.

What to Look Out For

Closed-end funds are a specialty. A CEF may look attractive if it trades at a discount to net asset value, but discounts may persist for long periods of time, and higher expenses and poor active management might lead to underperformance. See Further Reading below for more on investing in CEFs.

Closed-end funds tend to have higher expense ratios than ETFs, and may be more expensive to purchase and sell as their lower trading volume may result in wider bid-ask spreads.

Because municipal bonds may be free from federal, state and local tax if purchased in the state in which they are issued, municipal bond funds tend to be tailored to residents of a particular state. If you purchase a national municipal bond ETF or closed-end fund, you may not receive the full potential tax benefits of municipal bonds.

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